By Staff Planner, Virginia Dhondt
Under current rules, a retirement plan owner can designate a beneficiary to inherit his or her IRA or qualified retirement plan such as a 401(k) plan. Generally, the Inherited IRA must be distributed either over the beneficiary’s life expectancy or by December 31 of the fifth year after the original owner’s death. The five year option is generally used when there is no designated beneficiary. The distribution over the beneficiary’s lifetime is commonly referred to as a “stretch IRA” because it allows taxation of the IRA to be deferred over a much longer time, especially if the beneficiary is a grandchild.
When the designated beneficiary is the IRA owner’s spouse, the spouse beneficiary will need to decide whether assuming or inheriting the IRA is the best option. Choosing to assume an IRA from a spouse moves the assets into the surviving spouse’s IRA as if it were his or her own, whereas inheriting the IRA creates an account in the name of the original owner for the benefit of the surviving spouse. When the surviving spouse assumes the IRA, the assets are subject to the surviving spouse’s own required distribution rules; when he or she inherits the IRA, the assets are subject to inherited IRA rules that apply to any designated beneficiary.
Under a proposal by Senate Finance Committee Chairman Max Baucus (D-Montana), attached to the Highway Investment, Job Creation and Economic Growth Act of 2012, the stretch IRA provision would apply only to a very limited definition of an “eligible” designated beneficiary. Eligible beneficiaries—the surviving spouse, a disabled or chronically ill individual, someone who is not more than 10 years younger than the original IRA owner, or a child who is still a minor—would still be able to use their own life expectancies for lifetime distributions. Note that IRA owners who have disabled or chronically ill individual beneficiaries should seek professional advice to determine if planning for special needs is required.
In addition, once an eligible beneficiary dies, the successor beneficiary would be subject to the five year rule to ensure that the IRA is not used for multiple generations. If the successor beneficiary is a minor, the five year rule starts when the child reaches age of majority.
If passed, this provision would apply to deaths beginning in 2013, including the death of a beneficiary of a current Inherited IRA. In other words, a beneficiary of an IRA that is inherited prior to 2013 would leave an IRA that is subject to the five year rule for his or her (successor) beneficiary.
While distributions from Roth IRAs are tax-free, Roth IRAs are subject to the same distribution rules at death as IRAs. This means that Roth IRAs will be distributed in many cases under the five year rule and then the assets, no longer in a tax-free Roth IRA, will generate taxable income to the beneficiary for the remainder of his or her life.
Although the proposal to fund the transportation bill may not pass, it is receiving attention and could be seen again. If it were to pass, it would be expected to generate about $4.6 billion over the next ten years by accelerating tax revenue.
There are many planning implications to be examined as this develops. However, the provision is not in the House version of the legislation, so no action is warranted at this time. Please contact KeatsConnelly if you have concerns about your US retirement plan beneficiary designations.